With the credit crunch
now taking second place to worries about inflation, interest rate futures are
pointing to significantly higher official UK interest rates in the next two
years. This is a sharp turnaround from a few months ago when they were looking
for deep cuts. But the rise in consumer price inflation to 3.3% in May and the
prospect that it will peak at well over 4% this year has led to a sharp change
in sentiment in the financial markets. Moreover, UK consumers seem immune
to the pressure from rising inflation, higher mortgage borrowing costs, falling
house prices and lower confidence. Retail spending refuses to fall, rising by
3.5% in May to stand 8.1% higher in volume terms than in the year before. Our
view is that employment growth is the key to this and as some people give up on
owning a home, or moving near term, and spend instead, leading to lower savings
and strong growth in sales.

...this could lead to
higher interest rates...

With inflation rising,
there is a clear risk that the MPC may be forced to raise official interest
rates significantly higher, despite weaker overall growth. Because of this, we
have calculated two scenarios, one where interest rates move in line with
financial market expectations, as suggested by forward sterling interest rates,
and a second where Bank rate is 2% higher than in our base case. The base case
assumes only one increase in UK official interest rates,
in early 2009 when the effects of the credit market crisis are fading and the
implications of higher consumer price inflation for the economy are clearer.
The results of this exercise are shown in the following charts. And the outcomes
are clear: the Bank of England must be careful not to raise interest rates too
much too soon. Such an outcome could make the unfolding economic slowdown too
excessive, and lead to consumer price inflation undershooting the official 2%
target in 2010. At the same time, our analysis shows that some increase in
official interest rates seems necessary for inflation to hit the 2% target. But
for that to happen, a period of below trend growth (2.3-2.6%) this year and
next is inevitable.

...but our scenarios
show that excessive rate hikes could lead to recession and inflation undershooting
the target in 2010...

UK economic growth would
slow to just 0.8% in 2009 if base rates were raised to 5.75% by September of this
year. If base rates are raised by 200 basis points, i.e. to 7%, the UK would experience
recession in 2009, see charts. That sets the limits for any rise in UK Bank
rate, with anything above 1% likely to cause severe economic dislocation. This
is in line with the analysis we did in 2007, which showed that UK Bank rate
above 6.5% would lead to a contraction in economic output. One reason is that
with UK households highly
indebted a rise in base rates would raise repayment costs to such high levels
that consumer spending would be cut back dramatically and consequently growth
would fall back sharply, see charts. Another reason is that manufacturing
output would also fall, leading to a decline in profits, lower investment
spending and sharply lower employment. As this process takes hold, a vicious
circle develops with further cuts in consumer spending as rising unemployment
combines with significantly weaker earnings growth.

...so the MPC needs to
tread very carefully in raising Bank rate

This latter position
would be in sharp contrast to the present situation, where it is rising
employment that seems to be one of the main bulwarks against recession, as it
keeps total employment income rising, even as inflation erodes real spending
power. Of course, if unemployment rose then house price falls and mortgage
arrears would ratchet very sharply, alongside higher company default rates.
But, as chart h shows, with Bank rate at 5.75% through to 2010, the inflation
target would be sharply undershot. And if rates were raised by 2 percentage
points to 7%, there would be falling prices. The MPC would be far too aware of
this risk to allow it to happen, (Japan is a lesson to all) so one would
realistically expect official rate cuts to be taking place as early as February
of next year if they were indeed raised too high this year. This is one reason
why we believe that rate rises this year, and especially to the extent that
financial markets expect, are too excessive. A modest rise in rates, of perhaps
0.25% or 0.5% some time in early 2009 would be sufficient to bring consumer
price inflation back to target in 2010. Moreover, our analysis also shows the
futility of any attempt by the authorities in trying to get inflation back to
the 2% target in 2009. All that happens is an excessive slowdown that actually
does not even get inflation back to 2%, or

below, in 2009.
Inflation is set to fall back to target in 2010 - and to stop it from falling
below target the MPC should not overdo rate rises this year. But the analysis
also shows that Bank rate can only be cut from the current 5% if the economy is
close to, or in, recession.

Trevor Williams

Chief Economist,
Corporate Markets

Weekly economic data preview W/c
30
June 2008

ECB set to raise
interest rates; US June employment
report due

The ECB makes a point
of never 'pre-committing' to changes in monetary policy, but considering last
month's shift to a state of 'heightened alert' in the context of ever worsening
inflation data and the further 10% rise in oil prices since then, we expect the
central bank to lift the refi rate by 0.25% to 4.25% on Thursday. In the US, weak employment
trends should temper any support for a rebound in June non-farm payrolls on
Thursday and of an immediate rise in interest rates. PMI surveys of activity in
manufacturing and services sectors top the economic calendar in the UK but may not do much to
allay fears of a more abrupt economic slowdown and rising inflation as oil
prices reach new highs.

â€¢ Financial market
volatility last week and deteriorating forward-looking indicators of economic
activity in the euro zone could be a reason for some ECB council members to oppose
higher interest rates on Thursday. However, with no meeting scheduled in August
and inflation set to accelerate to well over 4% in the summer, double the ECB
target, we believe president Trichet will convince the council of the need to
respond this week. Nominal interest rates in the euro zone have been too low in
respect to the level of economic growth since last year and this carries some
of the blame for why inflation has accelerated the way it has. Higher oil and
food prices pushed CPI above 3.0% at the end of last year and are to a large
extent responsible for the rise to a record high of 3.7% in May (preliminary
figures for June are due this morning and may show a rise to 3.9%). Fears have
escalated that a sharp rise in inflation expectations among households could
lead employees to demand higher wages to compensate for the decline in
purchasing power. The threat of a damaging inflation-wage spiral could
destabilise the long term growth prospects of the economy and goes to the heart
of why the ECB's mandate is centred on maintaining price stability over the
medium term. With inflation only forecast to hit the 2% target in 2010, it is
hard to see the ECB postponing a move this week. The grim inflation outlook means
the pressure for tighter monetary policy is likely to remain acute in the 2nd
half of the year, but does not imply that the ECB will embark on a series of
rate increases.

â€¢ The Federal Reserve
last week left interest rates on hold at 2.0%, but the threat of inflation led
one member on the FOMC to vote for higher rates. Whilst monetary policy in the US is loose in relation
to the level of nominal gdp growth, the case for an immediate rate hike is
harder to justify at the present time and we believe that the Fed will probably
leave interest rates on hold this year. The potential for stronger economic
activity is tied to the speed of a recovery in housing and labour markets. With
this in mind, we will concentrate on the June employment data due Thursday (US
markets are closed on Friday for Independence Day). Weak labour market
anecdotes last week, initial claims were unchanged at 384,000 and households
were gloomier on actual and future employment prospects, suggest that the
economy lost jobs for a 6th consecutive month in June. Our forecast is for a
decline of 50,000. The manufacturing and non-manufacturing ISM surveys are also
due this week and will offer some indication about the level of employment and
activity in both sectors at the end of Q2.

â€¢ In the UK, the week starts with
the release of mortgage lending data on Monday. Mortgage approvals have dropped
to an all time low in Q2 and we expect demand for new household borrowing to
have stayed at a low ebb in May, falling to Â£6.0bn from Â£6.4bn in April.
Nationwide house prices are due on Tuesday and given the nature of the survey -
it only considers approved mortgages - a fresh decline in prices is pencilled
in for June. High oil prices are forecast to have taken a toll on business expectations
in the manufacturing sector and this means that the sector PMI, due on Tuesday,
may struggle to stay above 50 in June. The services PMI is due on Thursday and
is forecast to show a rebound to 50.5, reversing some of the steep decline in
May. However, the Bank of England's is currently more preoccupied with
inflation and this implies that the output price components of the PMI's may be
more instructive for the Bank's most likely course of action on base rate over
the next few months. We still expect base rate to end the year at 5.0%.

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